Weekly Wrap-up: What's Next?

The following article was originally published at The
Agile Trader on Sunday, November 6, 2005.

Dear Speculators,

Throughout 2005 we have been working under the assumption that the stock market
(represented by the SPX) would behave a lot like it did during 2004, which
is to say that it would "goof around" in a trading range until late in the
year when seasonal factors would drive the SPX higher. We had anticipated that
2005 would form a "base over base," which means that for the most part the
2005 trading range would sit atop the 2004 trading range until the 4Q rally
would work to break the market up and out of that range for a run to new cycle
highs.

And that's pretty much what has transpired this year (pending the upside breakout)
despite all the noise in the media and in the markets themselves that has functioned
to force us to "disremember" just what's actually going on. With only brief
exceptions, in 2005 the SPX has traded between 1163 and 1225. And each breach
of that range has been met with a swift regression back inside the envelope.

A "base over base" is generally accepted as a bullish formation and the highest
likelihood is for an upside resolution to the pattern. Last week the market
continued the anticipated high-volume upside move that fits with metronomic
precision into our forecast for a rise out of a late-October low. But this
coming week will be telling as the SPX encounters resistance in the 1225-45
band.

As we discussed last week, a move over 1253 projects a test up to 1291 (66.7%
retracement of the '00-'02 bear market) and a move above 1291 would bring 1368
into play as a target (76.4% retracement of the bear market).

But what comes next? What's in store for 2006? As we move toward the end of
this year all eyes will focus on next year.

In studying the congruence of SPX performance from Oct. 1990 – Nov.
1993 to its performance from Oct. 2002-Nov. 2005 we may have stumbled on to
something of paradigmatic importance.

On this chart the blue line tracks the SPX performance beginning 10/11/90,
which was the low prior to Operation Desert Storm launched in early '91. The
red line tracks the SPX performance beginning at the 10/9/02, which was the
low prior to the Iraq Incursion launched in early '03. The correlation coefficient
for these 2 series is +0.90 (where +1 is perfect and -1 is perfectly inverse).
As of trading-day #776 in both series the SPX gain is 57%.

In 1993-4 the SPX had another 4% upside left in it from the analogous moment
in time, topping out on January 31.

Now, whether this particular analogue will continue to display such a shockingly
close fit remains to be seen. But after studying this chart I became curious
about the larger context and so I had a look at the SPX 4-year cycles.

There's a lot going on in this next monthly SPX chart, so let's break it down:

The black line in the top pane is the SPX. It's scaled logarithmically
so that the action at much lower price levels is readable.

The squiggly red line in the bottom pane is the 12-Month Disparity Index
(12-mdi). The 12-mdi shows the SPX monthly close relative to the 12-month
moving average (12-mma). E.g., a 12-mdi of +0.10 means that the SPX closed
10% above its 12-mma.

We learn several important things about market history from this study.

Since 1962 each 4-year cycle low (blue line) except for 1986's has brought
the SPX down below its 12-mma (12-mdi below ZERO). The lone exception in
1986 was not really an exception but more of a delay with a steep price
paid for the delay in October 1987. So, we can expect, based on history,
that the SPX will be below its 12-mma sometime around September 2006.

Point A on this chart marks the October '90 low studied on the prior chart.
And point B marks the October '02 low also studied in that prior chart.
So, the remarkable similarity in performance between the 2 periods is at
least partly driven by the fact that each was launched at the 4-year cycle
low.

Now look at the dotted red vertical lines on the chart above. Here's what
caught my eye. In each cycle, if the market topped out at or prior to the
vertical red line (26 months after the cycle low or sooner) the fall into
the subsequent 4-year low (blue dotted line) tended to be quite harsh (points
C, D, E, F, and G). But when the market "translated" its top to the right
(when it kept going higher after the 26-month point in the cycle at the
dotted red lines) the ensuing 4-year low tended to be relatively modest
with subsequent rallies bounding to new highs ( points 1, 2, 3, and 4).

So, where does that leave us? The most recent red dotted line came at the
end of 2004 with the monthly SPX close at 1217. Since then we have seen incrementally
higher monthly closes (as high as 1234 last July), but no marked upside progress
(the SPX is now at 1220). If the 4Q rally gains some significant traction and
heads for 1291 or 1368 (higher highs MORE THAN 26 months into the 4-year cycle),
then the odds favor a relatively shallower decline into the 4-year cycle low
in September '06. But if the 4Q rally CANNOT produce a significant breakout
then the decline into the Sep '06 low is likely to be nastier and more aggressive.

To sum up: A 4-year cycle low that will take the SPX below its 12-month moving
average is due in September '06. If the market can push to significant new
'05 highs during 4Q05, then the Sep. '06 low is likely to be relatively mild.
If the SPX cannot move aggressively to new highs in 4Q05, then the retrenchment
into the Sep. '06 low is likely to get nastier.

**** **** ****

WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)

For those of you who are new to our Weekly Wrap-up our WENDI work involves
reviewing the prior week's major economic reports. We assign each report a
value anywhere between -1 and +1 in half-point increments. So, a very bearish
report would get a -1, a very bullish report would get a +1, and, say, a qualifiedly
bullish report would get a +0.5. We then sum the individual scores, divide
by the total number of reports, and multiply that quotient by 100 to derive
the Weekly WENDI, which is expressed as a percentage of anywhere between -100%
and +100% (the former being maximally bearish and the latter being maximally
bullish).

The Cumulative Weighted WENDI is the running sum of the individual scores.
And the 4-Wk Weighted WENDI is the sum of the past 4 weeks' individual scores
divided by the total number of reports over the same period, and it tells us
about the momentum in the flow of economic news.

The most recent Weekly WENDI jumped up from -9% to +24%, a decided turn for
the better.

The Cumulative Weighted WENDI popped up by +4 points to +245, turning momentum
slightly positive after deterioration in the post-Katrina September-October
period. The 4-Wk Weighted Moving Average pipped up again to +1% after having
dropped as low as -19% in mid September.

The flow of economic news appears to be on the mend as the negative effects
of Hurricanes Katrina, Rita, and Wilma slowly recede. And we expect WENDI to
dance somewhat higher as 4Q05 progresses toward the holiday season.

For the propeller-heads among us, here are the components of our WENDI score.
If you left your propeller hat at home, feel free to skip ahead:

FACTORY ORDERS: (-1) September's orders fell -1.7% with Core New
Orders down -1.5%. The outlook is probably OK for 4Q but 3Q GDP revisions
will be down a bit.

ISM NON-MANUFACTURING: (1) Rebounded sharply (7 points to 60) after
the post-Katrina dip. Should continue strong at least through 4Q.

PAYROLLS: (-0.5) Headline Payrolls number was a disappointment (+56K)
and revisions were net negative. Post-Katrina data is a bit iffy, however.

**** **** ****

EARNINGS

The consensus estimate of Forward 52-Week EPS for the SPX fell last week from
$85.02 to $84.56 (blue line below).

In consensus for EPS growth over the coming year is 12.6%. Trailing 52W EPS
fell from $75.48 to $75.31. Ordinarily that could be cause for concern. It
would be except that the Energy sector experienced a -2.75% decline in its
consensus F52W EPS estimate. So, by the same token that the market has been
somewhat skeptical of the surge in the F52W consensus as estimates for the
Energy sector were rising, the market may become more enamored of its prospects
as Energy prices decline and estimates for that sector retrench.

There has been some deterioration in the consensus for Consumer Discretionaries
and the Materials sector, but the story has been so monopolized by Energy that
it's hard to see anything but the yellow line on the chart above. Meanwhile,
however, since July '04 the consensus for EPS growth in each of the SPX's 10
sectors continues to rise (from +5% for Health Care to + 34% for Telecom Services).

The SPX PE on F52W EPS has risen by +0.4 to 14.4 over the last 3 weeks.

The market remains inexpensive relative to historical means as well as relative
to the 10-Yr Treasury (Price/Dividend Ratio of 21.5).

Equity Risk Premium (ERP), defined as the Forward Earnings Yield on the SPX
(6.93%) minus the 10-Yr Note's Dividend Yield (4.66%) is now at 2.27%, still
quite high by historical standards but noticeably lower than the recent high
of 2.77%. With interest rates rising and the stock market rallying ERP is shrinking
back toward its post 9/11 median of +1.90%. We would continue to expect ERP
to shrink and for the 10-Yr's dividend yield and the SPX's earnings yield to
move toward one another.

We would expect that before the year is out the trend toward convergence of
the SPX and our Fair Value Calculation will have the blue and red lines on
this chart "kissing" somewhere in that 1290 area suggested by our Fair Value
calculation and the "66.7% retracement of the bear market" target discussed
early in this report.

**** **** ****

In Monday's Morning Call we'll look at some important sector charts. But we'll
be watching for continued leadership in the Transportation sector (the Dow
Transports have broken to new all-time highs), the Nasdaq 100, and the Financials.
We'll need to see the Semiconductors contribute some positive Relative Strength,
however, if this rally is to sustain its strength.

Let's continue to watch for Crude Oil's breaking below $58. If that happens,
then prospects become more sustainably bull for both the market and the US
economy.

Note: Our mechanical trading model (the Dynamic Trading System) now has profits
on 10 out of its past 11 trades on the SPYders and the Qs, including our two
open positions. With the return of more normal volatility to the stock market
we expect that the System will continue to display its historically profitable
returns.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS,
SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY
ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.
IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE
RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING
PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS
IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION,
HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING
RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.
FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING
PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY
AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO
THE MARKET IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM
WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE
RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

DOG DREAMS UNLIMITED INC.(DDUI), WHICH OWNS AND OPERATES
THE AGILE TRADER, HAS HAD LITTLE OR NO EXPERIENCE IN TRADING ACTUAL ACCOUNTS
FOR ITSELF OR FOR CUSTOMERS. BECAUSE THERE ARE NO ACTUAL TRADING RESULTS TO
COMPARE TO THE HYPOTHETICAL RESULTS, CUSTOMERS SHOULD BE PARTICULARLY WARY
OF PLACING UNDUE RELIANCE ON THESE HYPOTHETICAL PERFORMANCE RESULTS.

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